Description

Investment Thesis

Pure Cycle - long term, major upside, modest downside. The business has two kinds of segments: water rights and land to be developed. Segments are independent of one another, yet the land will accelerate water income. Each segment alones justifies the current valuation. 

Business Segments

Land - Sky Ranch

The business owns ~930 acres in the east Denver metropolitan area. They bought it after the financial crisis for $7.5m. PCYO already had water rights in the area, which they wanted to begin selling. PCYO bought the land in 2010, which was bought earlier for about $50m. The company is developing a community of 3,200 homes and 2m SQFT of commercial, retail, and light industrial development. The whole project will take about 10 years to develop.

Currently, there are more than 120 residents in the neighborhood, up from 70 in the 1st Q. 

The first phase is running and will have 506 single-family residential homes with a low-entry price range ($325k). PCYO has three agreements with different developers: Richmond American, Taylor Morrison, and KB Homes. By Nov 3rd 2020, PCYO completed and delivered all of the 506 lots to the homebuilders (up from 277 at the end of last year), as they expected last year that they will. The home builders already sold 365 homes (up from 100 12 months ago) - 2 years ahead of schedule. They believe that the 140 homes remaining will be sold in 2021.

The overall construction costs of the first phase were $36m (/506=$71K per lot). Lot sales were about the same ($71K per lot, breaking even), but in addition, the company got $13.7m in tap fees (which will be later discussed) and $10.5m of reimbursable, that will grow to $29m total (also - to be discussed). 

In his last letter to shareholders (Dec 1st), Mark Harding, CEO and President, said that the company is on track to launch the development of the second phase of Sky Ranch this month (Dec 2020). It is 250 acres of residential development (1st phase is 150) and 160 acres of commercial, retail, and light-industrial development. The company “entered into contracts with four home builders to sell 789 finished lots, on which the home builders will construct both attached and detached single-family residential units”. The company keeps 100 for itself for future purposes. The total sales for the 789 lots are $63.4m (the other 100 worth around $9-10m).

For this stage, the company is expected to spend $66m on development, with lot sales of $73m, reimbursements of $48m and tap fees of $21m - which leaves us with profits of ~$75m. 

The third phase will be 300 acres big and we heard less about it from the management, therefore I will leave it to further discussions. 

Here I would like to mention that I like the development rate here. In some businesses, we would like to see rapid expansion. In others, we would like to see more moderate actions - that will

a. Bare less debt, and 

b. Will not burn land inventories too quickly, and allow price changes to positively influence the business.

Following PCYO for the past 2-3 years, I can definitely say that they took the second approach. The debt burden is very low and they smartly divided the project into 3 phases for more than a decade of work. 

Sky Ranch - Unit Economic. Two kinds of revenue streams: (1) sold lots (2) tap fees (measured by SFEs: single-family equivalent, 1 water tap per 1 customer). 

Non-Recurring Revenues

1. Lot Sale - in the first phase, PCYO charged around $70,000 from the developers for a developed lot, and currently, in the 2nd stage, they charge about $80,000.

2. Public Improvements - PCYO is investing in public facilities and utilities in the neighbourhood. PCYO is expected to get reimbursement of $29m for these expenses from the municipal district when it raises bonds in the future, for the first phase alone (and it already got 10.5).

A little bit of math. PCYO invested in the first phase $36 (up 1m from expectations), including utility investments of $29m improvements to be reimbursed. Lot sales provided a near amount. So that’s breaking even. But the company also gets $29m reimbursements (±$49k). I will consider it as $50k from now on. 

Ⅲ Water & Sewer Taps - the company is also the provider of water and waste management serviced for the revenue. The company charges $4,752 (up from $4,600 last year) for a sewer tap and $27,209 (up from $26,500 last year) for a water tap, and they estimate they will have around taps (SFEs). In the Q2 2018 call the CEO said that those have a 50% margin, so that’s ~$16,000 per SFE (let’s say $15,000). [BTW - Margins are probably higher now, as they raised prices]

The company says it will sell 3,200 residential lots. 15k (taps) + 50k (lot) = ±$65k per lot, which is ±$208 in NOI for the total lot sales. 

In addition, the company has 2m SQFT commercially zoned land. Unlike residential land that is sold per lot, I wasn’t able to find the numbers for the 160 acres development costs nor potential revenue, so I will not consider that. Part of the commercial land will be developed in the 2nd stage and part of it in the third. The commercial area will also have about 1,600 SFEs, so that’s another ±$24m in NOI. 

So the total NOI of Sky Ranch is about $230m (rounding down with a few discounts, not including the sale of commercial land).

Recurring Revenue

The company will sell water and waste management for the Sky Ranch neighborhood in the future. PCYO says that they will get around $1,500 a year from each of its 5,000 SFEs (Q4 2019 call). That’s about $7.5m a year of water biz - that should get a high multiple in the future. 

Water and Wastewater (In addition to Sky Ranch)

In 1996 the company bought its water rights in the area of Lowry, Denver (Rangeview). The Lowry Range water rights are about 27,000 acres in size (the company also has 2,200 acres in different areas I will not focus on due to their small meaning to the business currently). Later, in 1997, they went into an agreement with the Rangeview district to provide wastewater service in the Lowry Range.

Pure cycle believes that in potential there will be around 60,000 SFEs (1 SFE = 1 customer), not including Sky Ranch. Besides Sky Ranch, PCYO already supplies water for 649 (up from 462) SFEs and 384 (up from 214) wastewater SFEs - it’s not meaningful, but the trend is there (Table 1). 

The unit economy here is the same as in Sky Ranch: initial $4,752 for wastewater, $27,209 for water, and $1,500/customer/year. 

THEORETICALLY, PCYO sits on a gold-mine-in-potential of $1.8b in initial installment ($0.9b gross) and another 90m in yearly revenues. We need to be cautious about it. This area is undeveloped and the growth of sales here is VERY low (although we saw a recent rise), as one can see in Table 1. So, again, that's only a potential.

Table 1

Year 2020 2019 2018 2017 2016

Water 649         462         391         391         258

Waste 384         214         157         157         157

Water / Oil Fracking

Near PCYO’s water supply system, there are some fracking operations. Harding mentioned 16,000 wells used in a single time and that each well is worth around $150k (potentially $2.4b) for PCYO. Each well equals 200 homes in its water consumption per year. Currently there are about 100 wells (<1%). So, if oi prices rise, and fracking in the area are not forbidden, we could see a nice potential here as well. But - a reminder - that’s not the end goal here. That’s only a method to spend time & earn money while the city develops.

Other things to take in mind

1. Water Demand - Water demand will only go up while the supply will remain about the same. 

2. Inflation -  Therefore no need to discount inflation because they will also raise prices (as they did this year)

3. Other Businesses - The company has other businesses that could create some revenues in the future, like oil royalties (creates $150k a year per well, currently only one well), some mineral rights that could one day be worth something.

4. Debt - 0.

5. The company also gets royalties from O&G explorations in it’s properties (650K in 2020).

Valuation

PCYO doesn’t need to get 60,000 customers or to frack 16,000 wells in order to be worth more than it is today. 

The company trades for $245m. The market evaluates it with a small premium to Sky Ranch. PCYO will probably have a net income of about $150-200m from Sky ranch, and one should add a high multiple on the $7.5m to the recurring water sales (peer comparison shows a min of x5 EV/revenue of sales, an average of x8). 

So for a few tens of millions of dollars, you get this great water system, ready to deliver water to newly developed neighborhoods in east Denver. And until that happens, as long as oil is around $40-50, it can sell its water for fracking. And it has zero debt and many catalysts. So, I guess that we are OK where we’re at. 

Risks

1. Management can’t return value to shareholders - Since we have no experience with the return of value, we can’t be sure how done it will be made. 

2. Sky Ranch's next phases might take some time to take off if any crisis hits. The company has no debt so it's not a major problem, rather a delay. It will have great influence in the short term, but long term inherent value will remain the same.

3. Management raises debt for projects it will find it hard to monetize down the road.

4. Red Flag - Harding (CEO and President) only owns ~2% of the company and sold some stock earlier in the year.

Catalyst

Catalysts

1. Denver keeps on developing east, outside of municipal areas

2. Sky Ranch starts to deliver solid income from water

3. As that happens, PCYO will get into more water ETFs

4. Sky Ranch phase two & three